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Use appreciated stock to fund member withdrawals
Issue:
Understanding withdrawals - how to save your club and the withdrawing member money and headaches.
Cause:
Paying off a member in cash, and later selling an appreciated stock can result in reporting more taxable income than has been realized. The reason for this is that the withdrawing member who receives cash is going to be taxed on his share of the appreciation on that stock at the time of withdrawal. The remaining members will also declare the full amount of the gain on that appreciated stock when it is sold, even thought there is one less partner to whom the gain can be allocated. This means that at the time that stock is sold, the IRS will have realized tax on more than the gain on that stock. This imbalance will be corrected as the remaining members leave the club, but that could be years down the line.
Resolution:
Assume a two member partnership, made up of Able and Baker, each of whom contributes $10,000.
They buy StockA, 1000 shares for $10,000.
This stock zooms up and doubles in value, so you have a club worth $30,000 - $20,000 in StockA and $10,000 in cash.
Able and Baker are each worth $15,000, so each has a potential gain of $5,000 over his original investment.
Baker, being the cautious type, says "That's good enough for me. I want out". Able says "OK" and gets his friend Charlie to invest $10,000 in the club. So, at this point, before Baker withdraws, you have a club worth $40,000, made up of $20,000 in StockA and $20,000 in cash. Baker withdraws, receiving a cash payout of $15,000. He will pay tax on $5,000, the difference between his original contribution of $10,000 and his payout of $15,000.
The next year, the club sells StockA for $20,000. They paid $10,000 for it, so there will be a gain of $10,000 to be allocated to the two remaining partners, Able and Charlie. Consider what has happened to this point. The only gain that has been realized is from the $10,000 increase in StockA from $10,000 to $20,000. Yet there has been $15,000 reported to the government - $5,000 on Baker's withdrawal, and now $10,000 on the sale of StockA. In other words, members of this club have reported too much income to the IRS in the amount of $5,000. This overpayment will be made up as each of the remaining members leaves the club, but that could be years in the future.
To avoid this prepayment, use StockA to fund the withdrawal to Baker. Indeed, if you transferred 750 shares of StockA to Baker, valued at $20 a share, Baker will have no tax until he sells the stock, and then he will have the same $5,000 gain that he had with a cash payout, assuming the stock price stays the same. When the remaining 250 shares are sold, there is only a gain of $2500 to split up between Able and Charlie. So, at this point the club has succeeded in reporting only $7500 of the $10,000 gain realized. Able and Charlie will report the remainder when they leave the club.
The moral of this story? Use appreciated stocks to pay off members to avoid prepaying your taxes, maybe even pay less taxes for a number of years. And that is true even if you have enough cash to fund the withdrawal without transferring stocks. Use that cash to restore your position in the stock transferred or to buy a new stock.
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